Preparing for the Next Recession

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A recession is coming. As long as the economy moves in cycles, a recession will always be coming. Right now there is more talk about a downturn than usual. You can’t pick up a newspaper or click on a financial site without finding some discussion of recession indicators and concerns.

What should you do?

Understand that my track record at predicting recessions and timing the market is no better than anybody else’s. I stopped trying long ago. That said, I have invested through several recessions, and expect to live through several more.

What experience I have, I will share, along with my own preparations and thoughts as we face increasing prospects of an economic downturn….

History

My memories of the dot-com crash are starting to fade. It was mostly a footnote to my financial progress. At the time our net worth was around $500K, so we had meaningful investments, but I was nowhere near financial independence or retirement. I knew enough to keep investing in broad-based, low-fee mutual funds, and I didn’t change my strategy. Though I did lose money in some small speculations on the side.

The Great Recession of 2008-2009 was another story. My net worth had recently crested $1M and I was beginning to entertain thoughts of early retirement. I was reading everything I could find on the topic. I was also playing with the rudimentary retirement calculators of the day, as well as running my own models.

Then the bottom fell out of the stock market and the economy. This time around I knew much more about investing. I rebalanced my portfolio as best I could. I kept up my 401(k) contributions, even increased them near the bottom. But, though I still expected to retire early, I gave up all hope of retiring on any schedule. That would have to wait for economic conditions to improve, and it was several years before I could revisit the question.

When I finally did retire in April of 2011, the economy was much more auspicious. In fact, we now know it was the start of a record bull market.

That market, I’ll admit, has made the first stage of my retirement much easier. The threat of sequence of returns risk has steadily diminished with each passing year of growth. After the first half-decade of early retirement, no longer obsessed with running retirement calculators or honing our budget, we’ve been able to put our finances on autopilot, and spend some extra on luxuries.

But, neither you, nor I, should be seduced into recklessness by the ease of my first decade in retirement. We are that much further into the economic cycle, and storm clouds are gathering….

Signs of Recession

Given that we are in the midst of the longest bull market in American history, it’s no surprise that pundits have been predicting its demise for some time. It could be tempting to dismiss them for crying wolf.

Except that markets have always been cyclical. Betting against that behavior seems a lot less wise than assuming we will again be in a recession eventually.

Add to that inevitability that some leading indicators have begun to lag. There is weakness in manufacturing and farming , and business investment is soft.

Another indicator, the yield curve for government bonds, has “inverted.” This means investors are willing to take less interest to lock up their money for longer time periods, because they believe the economy looks bad in the short term. It’s an arcane statistic, except it’s preceded every recession — on average 14 months in advance — for more than 50 years.

Add to those signs the trade war with China, with tariffs at levels we haven’t seen in most of our lifetimes, and global trade volume down. There are many reasons to be pessimistic about the economy now.

Though to be fair, there are positive indicators too, as well as indicators that haven’t turned negative yet. Consumer spending is a big one, though consumers are notably fickle and can easily shut their wallets at the first sign of bad news — economic or political. Also, unemployment remains low. Though it too is a short-term indicator, without much predictive value.

Finally, nobody can precisely predict the timing of economic cycles. As alarming as things might look, most experts don’t believe that a recession has started yet, and many don’t even believe one is imminent.

Preparing: Income/Cash

The most important area to address and protect in preparation for a recession or depression, in my view, is your income. But that means different things to different people:

If you are a 20- or 30-something, we’re talking having a job and job security. Being newer in your job and career, you may not have much of that, unfortunately. A recession could threaten your employment with layoffs. But there are still steps you can take to improve your situation: You can optimize your efforts at work to make sure you’re seen as indispensable. You can broaden and exercise your professional network, to make sure you have leads in the pipeline should you need a new job. And, you can beef up your emergency fund with 6-12 months of living expenses, so you don’t have to panic about losing lifestyle or a roof over your head if you’re between jobs for a while.

For a typical baby boomer retiree, it’s different. You probably have minimal to no pension, and a Social Security payment that doesn’t cover all your living expenses. Perhaps you have an annuity that smooths out your income stream. If so, that’s great. Though, unless it’s inflation-adjusted, you may still need to harvest investments to meet ongoing expenses over time.

For typical recent retirees, income security is all about cash on hand.

In the end, many of us will need to sell some investments from time to time to provide cash for living expenses. And it’s having cash on hand that prevents us from having to make those sales at the worst times during a recession.

How much cash do you need? In my second book I review statistics from the Schwab Center for Financial Research, retirement researcher Wade Pfau, and the National Bureau of Economic Research, on how long market cycles last. My conclusion: “Bottom line, to outlast a run-of-the-mill bear market, you should have three years of cash on hand. And for a worst-case recession/depression, you’d better have close to a decade worth of cash, plus other conservative investments you could rely on once cash runs out. “

Note, though “cash is king,” in a downturn, the bigger point is that you need liquid assets that will hold their value. Short-term bonds, gold, and other instruments can fit that description as well.

Preparing: Debt

No matter how much you plan, your income is likely less secure during a recession. That means this is a time, more than any other, to avoid debt.

Debt represents an ongoing obligation for your cash flow. If you can’t meet that obligation, the repercussions are huge: losing a house or vehicle, or being forced to sell assets at a loss.

I’m never a fan of debt, and the implications for debtors during economic hard times are one major reason. As Warren Buffet famously says: “You only find out who is swimming naked when the tide goes out.” You don’t want to be caught overexposed to debt payments during hard economic times.

Not only debt, but any ongoing financial commitment is burdensome during a recession. So this is also a questionable time to be signing up for expensive new memberships, or subscriptions, or any ongoing inflation of lifestyle.

Preparing: Investments

What about your investments, specifically your asset allocation? Should that change going into a recession?

Generally, the answer is “NO.”

Because the timing of a recession is not predictable, your asset allocation should be designed to NOT need adjustment just because one is on the horizon. You should own the mixture of stocks/bonds that lets you sleep at night without needing to predict what kind of economy you’ll wake up to the next morning. That’s the whole point.

That said, if this is your first recession and you’re realizing that you are more risk averse than you thought, or don’t know how risk averse you are, then making your asset allocation more conservative might be warranted.

And, if you’re a current retiree who needs cash for living expenses, and decides that now is a good time to sell potentially overpriced assets, I would not criticize. In fact, I’ve made that move myself.

Finally, one of the best steps you can take to prepare for a recession is to increase your knowledge and double-check your attitudes about market downturns: Do you understand that markets always go down at some point? That reacting after they go down is usually a terrible idea? That maintaining a diversified portfolio at all times is your best defense against panic and loss?

If you are unclear on any of these points, or doubting your commitment when the going gets tough, then more reading and thinking on long-term investing fundamentals are in order.

My Portfolio Checkup

I’ll end with a quick review of my own portfolio. I’m not in a panic by a long shot, but, yes, I’m concerned about the economy, and with maintaining our cash flow during the next inevitable recession. So this month I did a quick portfolio review, and made some small moves, to make sure we are prepared.

Much of our stock holdings are in two balanced funds: Vanguard LifeStrategy Moderate Growth (VSMGX) and Vanguard Wellesley Income (VWINX/VWIAX). Though there are some tradeoffs, such as not being able to access our stock or bond allocations separately, these funds greatly simplify our lives as we get older. They are “all weather” holdings that we don’t have to worry about managing. We can leave them alone for long periods of time, and withdraw from them as needed, without worrying about the state of the market. The ten-year return on VSMGX is 8.43%. The ten-year return on VWINX is 8.26%. Though it has been a bull market, those are wonderful returns for a conservative retirement portfolio.

However, there was one holding of mine that felt a bit over-weighted in the face of an aging bull market: Vanguard FTSE Social Index Fund Admiral Shares (VFTAX). This is a pure stock fund of mostly large-cap growth companies. The four top holdings are Microsoft, Apple, Alphabet, and Facebook. Though I’m an engineer and a fan of technology, I’m not wild about the headwinds facing these companies. Given that, coupled with the increasing possibility of a recession, I decided to make a small move.

This is what I do when I have concerns about my portfolio, but don’t want to overreact. I’ll make a small move of a few % that helps me feel like I’ve “done something” without making major changes in my asset allocation or long-term strategy. So this week, I moved about 2% of my net worth from those high-flying growth stocks to Vanguard’s Intermediate-Term Treasury Fund (VFIUX). It happened in a retirement account, so there were no tax implications.

Next, I harvested about 3% of our net worth out of Vanguard Wellesley Income (VWINX), as cash. That increased our cash reserves to about 3 years of living expenses. Though I generally feel good about VWINX, it has grown to an uncomfortably large proportion of our net worth (about 33%). Additionally, I’m not wild about any active management these days. And, though conservative, VWINX is actively managed. This sale was in a long-standing taxable account, so it will generate a capital gain. However the amount will be nowhere near large enough to push us out of the two lower tax brackets. So we’ll pay no tax on that gain.

My thought process when making investment decisions like these for harvesting income is always the same: If I take some money off the table now and the market keeps going up, no problem, we own enough stocks (more than 40% of our asset allocation) to benefit. On the other hand, if the market goes down, especially for an extended period, I will be very happy to have locked in a few more years of income. We aren’t needing or trying to get rich off the market these days. We just want to protect our nest egg from downturns (by holding enough bonds and cash) and from inflation (by holding enough stocks), while allowing for a little upside if things go well.

So, as I write this, my asset allocation has settled at 42% stocks, 39% bonds, 7% gold, and 12% cash. As mentioned, our cash reserves are enough to cover several years of living expenses. Beyond the cash, we have gold (ETF GLD) and bonds to last a decade or more. Those are assets that typically hold up well during recessions, and can even appreciate when the economy is in the doldrums.

So, my plodding, conservative portfolio is no speedboat, even in boom times. But, when the economic storm clouds gather and the seas begin to rise, the battleship-worthy diversification into reliable, old-fashioned asset classes is prudent and reassuring.

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Comments

Yield curve inversion does not always mean a recession. Many charts online present it as if this is the case, but it has de-inverted 2 out of 9 times without a recession since 1960. In cases of a recession average months until market top is 5, and average months until recession is 12. This all depends on if you look at a partial or full yield curve inversion…

Thanks Darrow for another timely article. I’m concerned with the tariff elephant in the room, as most experts are saying they could be a huge factor; that’s something new and different and unpredictable this time around.

As for my adjustments, until recently I was only at 10% bonds in my portfolio due to stable rental income. I am now at 21%, still low for a 60 year old. If the market takes a dive I plan on staying put… I think; it would be my first recession as a retired person so my thinking may change.

Darrow, on the Vanguard Lifestrategy funds is the expense ratio of 0.13 to .14% in addition to the expenses of the under lying funds? if it is would it not be better to invest directly in the under lying funds and then re-balance say once a quarter or more often or less as desired? For every million $ in assets it could result in annual savings of approximately $500. Your thoughts?

According to a Q&A with a Vanguard executive posted at Oblivious Investor, “Our funds of funds have no direct costs — the costs are derived only from the ERs [expense ratios] of the underlying funds.” There is still a potential savings by purchasing Admiral shares of the underlying funds, but it’s not worth the management overhead to me. I’m trying to simplify our portfolio for our later years. Others will have different objectives.

HI Darrow, very good article. One question why do you own the Intermediate-Term Treasury Fund for bonds instead of Vanguards total bond market index? Is it strictly due to the bond maturities and interest rate sensitivity? Or some other reason?

Hi Bruce, good question and I don’t have a perfect answer. My bond holdings are my stable anchor against my stock holdings. For that reason, I don’t want to hold risky/speculative/long-term bonds, which Total Bond Market would include. There might be an argument that the shorter-term/higher-quality bonds in Total Bond Market offset that risk, but Intermediate Treasuries seemed like a good, simple compromise to me.

Good article, Darrow. While my % of assets in stocks is still higher than yours, I have been periodically moving more into good dividend-paying individual stocks, dividend producing ETFs in Vanguard, and also my Vanguard bond ETFs. I have been more partial to the Vanguard Intermediate-Term Tax Exempt fund for many years, particularly when I was working still in our former abode in high tax New York. I still take some comfort in shielding some monies from taxes, even if the results are not as impressive as during my working days. Best of luck and continued good investing.

Sounds like you are still avoiding Annuities or Private Pension plans. I know that you have mentioned them in the past; possibly still in your future plans? They just seem like such a simple solution for a long-term retirement income, especially with “uncertainty on the horizon”.

As usual a thoughtful article on a topic which sometimes gets breathless treatment. You mentioned moving some funds from VWINX but not needing to pay tax on the capital gains as you are staying in the lower tax brackets. Have you considered being more active in harvesting capital gains (even just re-buying the same positions but establishing a higher basis) while you are in a low tax bracket that won’t require paying taxes on the gain? I’m not advocating trying to time a market top but taking advantage of your lower tax bracket to re-set your portfolio’s basis. Any reasons why you are not doing this more?

Thanks Stewart. Fair question. I realize this will blow some minds, but I don’t do capital gains harvesting because I don’t need to. We have enough money. I loathe gaming the tax system, especially when it costs me time in additional financial transactions and filing paperwork at tax time. Obviously, many people disagree, and I’m not arguing that anybody shouldn’t do this if they feel it’s worth their time.

I am sympathetic to your efforts to minimize hassle, administrative overhead, and time consumed implementing the various tactics we discuss here Darrow. I sometimes feel the urge to make changes, any changes, to feel like I am “doing something”, but I am often saved by the “potato chip bowl” syndrome. That is, as I am reaching for the phone to place a call to implement a change, I get distracted by the potato chip bowl next to the phone and forget to place the call. Most of the time, it works out for the better.

Thanks for your usual pithy and practical thoughts on the subject. Personally, I have recently changed my large-cap allocation from a cap-weighted ETF to non cap-weighted (FNDB). We’ll see.

This became a topic of especially keen personal interest to me during the 08-09 market meltdown, when my sophisticated, slice-and-dice “conservative” portfolio that backtesting showed “couldn’t” lose more than 8% had paper losses of nearly 25% and took years to recover.

Another commenter asked about your choice of intermediate-term Treasuries over total bond market and the answer is that IT treasuries are almost always the better choice, since unlike mixed-class bond funds they will save your bacon during a market panic and are also state tax-exempt, making their actual yields higher than they might appear. That’s why they are the default choice of bond experts like Annette Thau and Larry Swedroe – and the reason you see only Treasuries (either straight IT’s of a barbell of LTT and STT) in all four of the winning portfolios in Tyler’s article

The secret to Wellesley’s outsized returns over many decades has most likely been the exceptional skill of its corporate bond pickers, but who knows if such success will be repeated? I love the set-it-and-forget-it aspect of both that venerable fund and Vanguard’s LifeStrategy moderate or conservative growth funds but the large allocations to relatively low quality bonds, pointless allocation to international ones and high expense ratios are a deterrent. And based on their performance during the last major market crisis and their other structural weaknesses (no small/value tilt, no gold or other non-correlated hard assets) I don’t see think they’re likely to perform nearly as well in terms of either drawdowns or recovery times as the battle-tested allocations shown in the Portfolio Charts piece.

Of course another recession-proofing option is pulling a chunk of money out of the markets altogether. I don’t have the appetite to be an AirBnB mogul or start-up medical marijuana entrepreneur, but sometimes I kind of wish I did!

Thanks for the insightful comments as always Kevin. I appreciate the vote of confidence on intermediate Treasuries. And I will give more consideration to the issues with LifeStrategy funds, though an expense ratio of 0.13% is OK with me.

My wife showed me your article and is worried about the recession. We have $607K in 2 IRAs at Vanguard, $19K in a regular joint account. We have a combination of index funds at 60/40 Stock/Bond including both US and International. We have a mix based on the advice of Vanguard and have been maintaining that. In our bank, we have $31K check/savings (just enough in checking to manage with a savings account. We also have a $12K one year CD. We get about $40K SS and draw the rest of what we need out of Vanguard. We had enough non-IRA funds to get us through to age 70 taking only spousal SS and not touching IRA. On average over the past 4 years has been $4600 per month including two trips to Europe and other travel and Kitchen remodeling. This year we started our RMD and that will take care of all our basic needs and plenty more to keep a comfortable lifestyle. We own our home, no mortgage and two cars that are in good shape. We have no debts and always pay our credit cards in full each month. It’s the 3 years cash that is the question. How do we figure that? Three years of total needs and desires including what we get from SS? That would be about $160K. Three years of basic living expenses including what we get from SS? That would be about $140K. Or should we assume SS and keep three years of what we want or need besides SS? That would be between $12K and $20K. Lower end if we stay really basic. At the rate we are going, our RMD will be building and I’d like to keep more in Vanguard than at 2% or less at the bank. The only downside I see is that what we might have to sell a fund at a low point, but I figure if we are buying stocks and selling bonds (to stay at 60/40) we are going to manage without having $150K sitting in a bank savings account. Besides that, to get that much money into the bank we’d take a big tax hit. Given all that, how do we figure the amount of cash to meet that 3 yr standard?

Sorry I can’t give personal financial advice. But generally speaking when I look at this issue, I’m looking just at my cash flow needs. If I had other sources of guaranteed income, I’d be subtracting those from our required living expenses first. Also note it might not be strictly necessary to hold cash. If I hold bonds, especially short-term bonds, I could probably liquidate those at reasonable terms not matter what’s going on with the markets. But I’m very conservative, and like to hold a fair amount of cash so I’m not stuck in line trying to sell anything in a panic.

Thank you for your well timed post. Very helpful to let us go through your personal thought process. Most fear disclosing their decision making process to public. Everyone has different needs, fears, and personality. Haven’t we all read advice from financial advisers or Doctors then later discover their personal choices are completely different from what their selling. A couple come to mind that sell low risk and high security portfolios and later I read they are buying hot stocks for themselves. Nice, that Darrow puts to print his actual investments.

Your situation of living entirely off savings is a head game. Meaning the concern of losses is much higher and can’t be underestimated. When I was steadily producing income my investment worries were nil. Now that phase of life is over I’m checking markets daily.

My portfolio choices to date is a mix of low volatility safe (Wellesley) 25%, well behaved (Wellington) 50% and S&P 500 25%. It works out to 70:30. This is very conservative given my particulars of rental income and short time to Social Security benefits. In a few years after selling rentals will put that taxable money in VTI and put IRA money in Wellington.

To 2rd your Treasury duration choice, I read a respected piece on safe haven for “risk on” investment. Their analysis claimed the 10yr Treasury was best choice per history for the risk vs return. Also, read a respected piece on current bond market. A comment that it appeared that active fund might be a better choice at this time given strange market. So, I’m thinking I know little of the complexities of bond investing and to farm that out to one of the best financial advisers. No, not a neighbor, but Wellesley. They don’t charge as much and nationally rated as one of the best. In my judgement these low cost active balanced funds do have value to stem perceived volatility. They shift investments based on current financial risk. More stock or less, foreign, commodities, etc.

Those Lazy Portfolios choices for recession investing. Wellington did better that the rest for investors pulling money out on schedule. The 60:40 didn’t do near as well. Check out the “Juicy Portfolio” web site for interesting mix of investments and nice documentation. Problem is look at the performance of gold and the probable loss of ever repeating the performance in our lifetime. Same possible problem with bonds given the long duration high return success of old.

Hi Darrow,
You mentioned gold in your portfolio – I have some IAU (iShares Gold Trust). Do you own something similar or actual gold? If actual gold do recommend a (APMEX for instance) dealer? I’ve been reading as much as my time allows into whether to have bullion bars or shares of miners stocks. So far it seems easiest to have shares in the mining companies. But seems like having actual gold would be ideal, honestly I don’t know enough to answer my own question. Appreciate your thoughts. Thanks!

I’d love to rebalance my portfolio to increase my cash and reduce my exposure to potentially over-valued stocks, but doing so (perhaps resulting in significant capital gains) would result in me having to pay back most, if not all, of my 2019 health insurance subsidies that I get through the Affordable Care Act (i.e., Obamacare). So while I don’t mind paying the lower long-term capital gains tax rate, I do mind paying several thousand dollars more in income taxes — which, in effect, would mean that I’d be paying tons of money for my health insurance this year.

So, the big question is — would selling a noticeable amount of stock fund shares, before stocks start declining in price due to the recession, be financially worth it despite incurring several thousand dollars of taxes from losing all (of most of) the subsidy I’m getting from the ACA?

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